CHAPTER 10

PARTNERSHIPS: FORMATION, OPERATION, AND BASIS

Based on West Federal Taxation, Corporations, Partnerships, Estates & Trusts, 2001 ed.

1. OVERVIEW OF PARTNERSHIP TAXATION

1. FORMS OF DOING BUSINESS B FEDERAL TAX CONSEQUENCES p.10-2

1. Pass-through entities (partnerships and S corps) are not taxed separately.

Income passes through the organization and is taxed on the individual
partners= (or shareholder=s) return

2. Avoids the double taxation that is involved with most corporations=

distribution.

3. Administration and filing requirements are simpler for partnerships

4. When dissolving a partnership, the liquidation is tax-free unlike a corporate

dissolution.

2. WHAT IS A PARTNERSHIP? p.10-4

1. Defined B Association of two or more persons (or entities) to carry on a

business each contributing money, property, labor, or skill, and each expecting
to share in profits and losses.

2. Four types of entities can be classified as partnerships:

1. General Partnership B has one or more general partners. Creditors can
sue the partnership or the individual partners. Each partner is
individually liable for debts (including malpractice claims) of the
partnership and the other partners.

2. Limited Liability Partnerships (LLP) B Much like a general

partnership. Major difference B> LLP partner not liable for any
malpractice committed by other partners

3. Limited Partnership B consists of at least one general partner (who is

liable to the creditors of the partnership) and several limited partners
(whose liability will not exceed their investment in the partnership).

4. Limited Liability Companies (LLC) B combines the limited liability

advantage of a corporation with the tax advantage of a partnership.
Those involved in an LLC are called Amembers@ as opposed to partners
or shareholders.

3. ELECTIONS RELATED TO PARTNERSHIP STATUS p.10-4

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 If an entity has two or more owners, it can generally choose partnership taxation or C
corp taxation. Remember Acheck-the-box@ discussion. Some partnerships may elect
out of partnership taxation rules.

4. PARTNERSHIP TAXATION p.10-5

1. Partners report their allocable share of the partnership=s income or loss for the
year on their personal tax returns. Some items on the partnership return retain
their identity on the partner=s individual return (e.g., ordinary income, capital
gains, charitable contributions).

2. A large partnership (more than 100 people) can be considered an Aelecting

large partnership@. In an electing large partnership only 11 items retain their
identity when traveling from the 1065 to the individual K-1. The other items
are netted against each other to simplify the K-1.

5. PARTNERSHIP REPORTING p.10-6

An informational Form 1065 and Schedules K-1 (for each partner reporting his share)
are required by IRS. Remember to review Schedule K on 1065 for a complete view
of the tax items of the partnership.
6. PARTNER=S OWNERSHIP INTEREST IN A PARTNERSHIP p.10-7

1. Each partner owns a capital interest and a profits (loss) interest in the
partnership.

1. Capital interest = (Assets B partnership liabilities) x partner=s

ownership interest.

2. Profits (losses) interest = partner=s percentage allocation of current

operating results. Look to the partnership agreement and any
amendments for the percentages designated for each partner. Be
careful B sometimes the profit interest is different than the loss interest.
The partner=s K-1 will designate all three percentages.

2. Partnership agreement may make special allocations or use different

percentages for various items such as tax-exempt interest if the special
allocation is a result of the partner=s contribution of capital to the partnership.
Always check the partnership agreement thoroughly to determine all
percentages and allocations that are to be applied.

3. Basis in partnership interest B Crucial to the effect taxation of a partnership is

the annual change in each partner=s basis in the partnership.
1. When the partnership passes on income to its partners, the partners=
basis in the partnership increases by the amount of taxable income
included on the personal return.

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 2. When a partnership passes on a loss to its partners, the partners= basis
in the partnership decreases by the amount of loss included on the
personal return.
3. This basis is not found on the individual K-1. Each partner (or that
partner=s tax preparer) must keep a running balance of his basis in the
partnership.

7. CONCEPTUAL BASIS FOR PARTNERSHIP TAXATION p.10-8

1. Aggregate (or Conduit) Concept B The partnership is treated as a channel for

tax related items to flow through to the individual partners. Partners are
viewed as being in an agency relationship with one another.

2. Entity Concept B The partnership is viewed (to a certain degree) as a separate

entity for legal purposes and in the requirement of filing a separate
informational tax return.

3. Combined Concepts B Concepts are blended to form partnership law and tax
consequences.

8. ANTI-ABUSE PROVISIONS p.10-9

The IRS is not blind. It realizes that partnerships are so flexible that abuse is likely to
occur. The IRS has left itself enough room to spot abuses and Arecharacterize@
income / loss as it flows from the partnership return to the partner=s individual return.

2. FORMATION OF A PARTNERSHIP (TAX EFFECTS)

1. GAIN OR LOSS ON CONTRIBUTIONS TO THE PARTNERSHIP p.10-9

1. A taxpayer can defer tax on his gain or loss:

1. when he transfers property to a partnership in exchange for a
partnership share OR
2. when he transfers property to an existing partnership.

2. The tax is deferred for two reasons:

1. Only the form of ownership has changed not the amount owned by
each partner.
2. The partnership interest is usually not freely transferrable so the
partner does not have a liquid asset that can be easily sold.
PROBLEM 15

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 3. Holding periods:
1. If the partner only contributes capital or depreciable assets, the holding
period for his partnership interest is the same as for the property he
contributed.
2. If the partner contributes cash or other types of assets (not capital or
'1231 assets), the holding period of the partnership interest begins on
the date of transfer to the partnership.

2. EXCEPTIONS TO '721 p.10-10 (These situations will not allow tax-deferral.)

1. Investment Partnership B What is primary objective of partnership? If

investment club, partners contributing stock or securities to partnership do not
get tax-deferred treatment on transfers.

2. Exchange B If the goal of forming the partnership is to trade assets among the
partners, the tax-deferred treatment is not allowed.

3. Disguised Sale B Watch for transfers of property into the partnership that are
closely followed by distributions of property.
1. A disguised sale is deemed to have occurred if:
(1) Contractual agmt requires a contribution by one partner to be
followed within two years by a specified distribution from the
partnership AND
(2) Distribution is to be made without regard to partnership profits
(therefore, no risks for the contributing partner exists).
2. Also watch for assumption of a partner=s liabilities by the partnership.

4. Services B If a partner receives a share of the partnership in exchange for

services he rendered, the transaction is taxable.
1. Partner recognizes the value of the partnership interest as
compensation (ordinary income) and his basis in the partnership is
increased by that same amount.
2. The partnership can either:
(1) deduct the value of those services as a business expense OR
(2) include the value of those services as the start-up costs of the
partnership and capitalize them.

3. TAX ISSUES RELATIVE TO CONTRIBUTED PROPERTY p.10-12

1. In General
1. Partnership=s basis in the property = Partner=s basis in the asset prior to
the transfer.
2. Partner=s basis in partnership interest = Partner=s basis in asset
transferred.
3. Partnership=s holding period for the contributed asset = Partner=s
holding period.
PROBLEM 17

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 2. Depreciation Method and Period B When partnership receives an asset from a
partner, the partnership must Astep into the shoes@ of the partner when
depreciation method and period is considered. No '179 expense is allowed by
the partnership on assets from a partner.

3. Receivables, Inventory, and Losses B When a partner transfers any of these

assets into a partnership, a determination must be made as to whether the asset
is to be taxed as ordinary income or capital income:

1. Receivables B Income realized is taxed as ordinary

2. Inventory B Income realized is taxed as ordinary if partnership sells
inventory within 5 years of the contribution date.
3. Losses B Compare partner=s adj. basis with the FMV on the
contribution date. If property is sold at a later date for an amount less
than the FMV on the contribution date:
(1) Adj. basis LESS FMV on contribution date = Capital loss
(2) FMV on contribution date LESS Actual sale price = Ordinary
loss (if sold within 5 years of contribution).
4. INSIDE AND OUTSIDE BASES p.10-14
1. Inside basis = adjusted basis of each partnership asset (look to partnership=s
tax accounts)
2. Outside basis = each partner=s basis in the partnership interest
3. At formation, the sum of the partners= outside basis will equal the sum of the
partnership=s inside basis.
4. When a partner sells his partnership interest for more or less than his outside
basis, differences will begin to appear when comparing the inside and outside
basis.

5. TAX ACCOUNTING ELECTIONS p.10-14

Most tax elections are made by the partnership as opposed to the individual partners. The
failure of a partnership to make an election does not transfer the election to the
partner. See list on page 10-15 for a complete list of elections made by a partnership.

6. INITIAL COSTS OF A PARTNERSHIP p.10-15

1. Organization Costs B can be amortized over 60 months beginning with the

month the partnership began business. (Be careful of cash basis vs. accrual
basis partnerships.) Items which are deductible include:
1. Costs which are incident to the creation of a partnership (i.e. legal &
accountant fees)
2. Chargeable to a capital account
3. See p.10-16 for items that are not considered organizational costs.

2. Start-up Costs B costs incurred after formation but before operations begin.
1. Not deductible
2. Can be capitalized

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 3. Upon election, can be amortized over 60 months starting with the
month when business begins.

3. Acquisition Costs of Depreciable Assets B i.e., changing the title of property

from partner to partnership.
1. Not deductible.
2. Must depreciate these costs as a new MACRS asset

4. Intangible Assets
1. If considered a '197 intangible, amortized over a 15 year period
regardless of the useful life. More common examples of '197
intangibles include:
(1) goodwill
(2) patents
(3) franchises
(4) trademarks
(5) covenants not to compete
2. If not a '197 intangible, then amortize over the asset=s useful life.

5. Syndication Costs
1. These expenses are capitalized.
2. Syndication costs are incurred when a partnership is disclosing its
financial situation to prospective partners.
PROBLEM 22

7. METHOD OF ACCOUNTING p.10-18

1. Can choose cash, accrual, or hybrid method of accounting.

2. Cash method is NOT available if:
1. Partnership is a tax shelter (i.e., interest has been sold in a registered
offering or partnership in which 35% of the losses are allocated to
limited partners) OR

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 2. Partnership has one or more C corporation partners. Exceptions where
cash basis is still available:
(1) C corp partner is a qualified personal service corporation OR
(2) Partnership is engaged in the business of farming OR
(3) Partnership meets the $5 million average annual gross receipts
test
(1) Partnership has not during any year after 1985 received
average (over 3 year period) annual gross receipts of
more than $5 million.
(2) The first year that the partnership exceeds $5 million
average annual gross receipts, the partnership must
switch to accrual basis from there on out.

8. TAXABLE YEAR OF THE PARTNERSHIP p.10-18

At the end of the partnership=s tax year, the income from the partnership will flow
through to the individual partners who report their income for their regular tax year.
Must determine when the partnership=s tax year ends. Use the following rules IN
ORDER:

1. Required Taxable Years

1. Partnership must use the majority partners= tax year. Majority partners
own a total of more than 50% of capital AND profits and all have the
same tax year.
2. Partnership must use the principal partners= tax year. Principal
partners own a total of 5% or more of capital OR profits.
3. Consider all principal partners tax years and calculate which tax year
would yield the least amount of deferral.

2. Alternative Tax Years B If none of the above options are satisfactory, the
partnership can petition the IRS for the use of a different tax year.
PROBLEM 23

3. OPERATIONS OF A PARTNERSHIP

1. IN GENERAL p.10-20

1. An individual, corporation, trust, estate, or another partnership can become a

partner in a partnership.

2. A partnership is subject to all other taxes (sales tax, property tax, FICA tax,
unemployment tax) and tax reporting in the same manner as any other
business.

2. MEASURING AND REPORTING INCOME p.10-21

1. Form 1065 B Due to the IRS by the 15th day of the 4th month; if the partnership
operates on a calendar year, this day falls on April 15th.

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 1. For smaller partnerships, copy of Sch. K-1 is provided to each partner
by this date.
2. For larger partnerships, the partners must receive their K-1s one month
earlier.

2. Income Measurement B 2-step approach. Certain items must be netted at the

partnership level and other items must be segregated and reported separately
on the 1065 and each Sch K-1.

1. List of pass-through items shown on p.10-21.

2. A partnership is not allowed to deduct
(1) Net Operating Losses
(2) Depletion of oil and gas interests
(3) Dividends received deductions
(4) Items that are allowed by legislative grace to individuals (e.g.
standard deductions, personal exemptions)
3. Partnership payments on behalf of a partner (possibly generating
itemized deductions to the partner) are treated as distributions or
guaranteed payments to partners.
3. Withdrawals C Capital withdrawals do not affect the partnership=s income
measuring and reporting process. Usually treated as distributions made on last
day of partnership=s tax year.

4. PenaltiesCEach partner=s share of income must mirror their Sch. K-1 as used
by partnership with the 1065. If treated differently, the IRS must be notified.
If a partner fails to notify, a negligence penalty may be added to the tax due.

1. Penalty for late filing of a partnership return = $50 per partner per
month (or fraction thereof, not to exceed five months) is imposed.

2. Partnerships with 10 or fewer Anatural persons@ or corporations as

partners are automatically excluded from these penalties.

3. PARTNERSHIP ALLOCATION p.10-24

1. Economic Effect B Partnership agreement can provide that any partner may
share capital, profits, and losses in different ratios. For example, a partner
could have a 25% capital sharing ratio, yet be allocated 30% of the profits and
20% of the losses. Economic effect test requires:

1. Allocation of income or gain to a partner must increase partner=s

capital account
2. Allocation of deduction or loss to a partner must decrease partner=s
capital account.
3. When the partner=s interest is liquidated, the partner must receive
assets that have a fair market value equal to the positive balance in the
capital account.

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 4. A partner w/ negative capital account must restore the balance to $0
upon liquidation.

2. Precontribution Gain or Loss B must be allocated among the partners to take

into account the variations between the basis of the property and the FMV on
the date of contribution.

1. For nondepreciable property, a built-in gain or loss on the date of

contribution must be allocated to contributing partner when property is
eventually disposed of in a taxable transaction.
2. If the property is depreciable, Regulations describe allowable methods
of allocating depreciation deductions.
PROBLEM 16, 19, 20, 27, 31

4. BASIS OF A PARTNERSHIP INTEREST p.10-26

1. Partnership interest can also be acquired after the partnership has been
formed. The method of acquisition controls how the partner=s initial basis is
computed.
1. If by purchase, purchasing partner=s basis is amount paid.
2. If by gift, donee=s basis is donor=s basis plus some or all of gift tax paid
by donor.
3. If by inheritance, generally FMV of the interest on partner=s date of
death.

2. The following operating results increase a partner=s adjusted basis

1. The partner=s proportionate share of partnership income (including
capital gains and tax-exempt income).
2. The partner=s proportionate share of any increase in partnership
liabilities.

3. The following operating results decrease the partner=s adjusted basis

1. Partner=s proportionate share of partnership deductions and losses
(including capital losses).
2. The partner=s proportionate share of nondeductible expenses.
3. The partner=s proportionate share of any reductions in partnership
liabilities.

4. Under no circumstances can partner=s adjusted basis for his interest be reduced
to zero.

PROBLEM 24, 28

5. Liability SharingCA partner=s adjusted basis is affected by the partner=s share of

partnership debt.

1. Partnership debt includes any partnership obligation:

1. That creates an asset

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 2. Results in a deductible expense
3. Results in a nondeductible, noncapitalizable item at the partnership
level.

2. Partnership debt defined B includes most debt considered a liability under

financial accounting rules except for accounts payable of a cash basis
partnership and certain contingent liabilities.

3. Under '752:
1. Increase in partner=s share of partnership debt is equal to a cash
contribution by partner.
2. Decrease in partner=s share of partnership debt is equal to a cash
distribution from the partnership to the partner. A partner=s share of
debt decreases as a result of either:
(1) A decrease in the total amount of partnership debt and
(2) An assumption of the partner=s debt by the partnership

4. Two types of partnership debt exist.

1. Recourse debt is partnership debt for which the partnership or at least

one of the partners (or a relative of one of the partners) is personally
liable. Recourse debt created after January 29, 1989, is shared in
accordance with a constructive liquidation scenario. Under this
scenario, the following events are deemed to occur at the end of each
taxable year of the partnership:

(1) Most partnership assets (including cash) become worthless.

(2) The worthless assets are sold at fair market value ($0), and
losses on the deemed sale are determined.
(3) These losses are allocated to the partners according to their loss
sharing ratios. These losses reduce the partners= capital
accounts.
(4) Any partner with a (deemed) negative capital account balance
is treated as contributing cash to the partnership to restore that
negative balance to zero.
(5) The cash deemed contributing by the partners with negative
capital balances is used to pay the liabilities of the partnership.
(6) The partnership is deemed to be liquidated immediately, and
any remaining cash is distributed to partners with positive
capital account balances.

2. Nonrecourse debt is debt for which no partner (or party related to a

partner) is personally liable. Nonrecourse debt is allocated in three
stages:

(1) An amount of debt equal to the amount of minimum gain is

allocated to partners who share in minimum gain.

Acct 432, Ch 10 Outline, Page 10

 (2) The amount of nonrecourse debt equal to the remaining
precontribution gain under Section 704c is allocated to the
partner who contributed the property and debt to the
partnership.
(3) Any remaining nonrecourse debt is allocated to the partners in
accordance with either their profit sharing ratios or the manner
in which they expect to share in future nonrecourse deductions.
The partnership agreement should specify which method is
chosen.
PROBLEM 26,35

5. Other Factors Affecting Basis Calculations B The partner=s basis is also

affected by the following:
1. Postacquisition contribution of cash or property to the partnership
2. Postacquisition distributions of cash or property from the partnership.
3. Special calculations designed to allow the full deduction of percentage
depletion for oil and gas wells.

6. LOSS LIMITATIONS p.10-32

1. In General

1. Partnership losses flow to partners for use on their tax returns, but the
amount and nature of the losses allowed in a partner=s tax
computations may be limited.

2. 3 different limitations may apply to partnership losses passed through

to a partner:

(1) Overall limitation contained in '704d

(2) At-risk limitation of '465 (If partnership loss survives limit #1,
then apply this limit.)
(3) Passive loss rule of '469. (If partnership loss survives limit #2,
then apply this limit.)

2. Overall Limitation B A partner may only deduct flow through losses to the
extent of the partner=s adjusted basis in the partnership.
1. Partner=s adjusted basis is adjusted for distributions and any
partnership gains during the year, but limitation is determined before
considering any losses for the year.
2. Losses that cannot be deducted because of this rule are suspended and
carried forward (never back) for use against future increases in the
partner=s adjusted basis.

3. At-risk Limitation B Under the at-risk rules, the partnership losses from
business and income-producing activities that individual partners and closely
held C corporations partners can deduct are limited to the amounts that are
economically invested in the partnership.

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 1. An individual partner=s invested amount includes his adjusted basis of
cash and property contributed and his share of partnership earnings not
already withdrawn.
2. A closely held C corporation exists when five or fewer individuals
own more than 50% of the entity=s stock under appropriate attribution
and ownership rules.
3. Partners cannot include nonrecourse debt in their amount at risk even
though that debt is included in the adjusted basis of their partnership
interest.
(1) Exception occurs when the debt is a qualified nonrecourse
debtCreal estate nonrecourse financing provided by a bank,
retirement plan, or similar party or by a Federal, state, or local
government generally is deemed at risk.

4. Passive Activity Rules B Loss may be disallowed under the passive activity
rules.
1. These rules apply to partners who are:
(1) partners who are individuals
(2) estates
(3) trusts
(4) closely held C corporation
(5) personal service corporations

2. Partners are required to divide their interests in partnership activities

into 3 groups:
(1) ActiveCEarned income, income or loss from a trade or
business in which the partner materially participates,
guaranteed payments received by the partner for services.
(2) PortfolioCAnnuity income, interest, dividends, guaranteed
payments from a partnership for interest on capital, royalties
not derived in the ordinary course of a trade or business, gains
and losses from disposal of investment assets.
(3) PassiveCIncome from a trade or business activity in which the
partner does not materially participate on a regular, continuous,
and substantial basis, or income from many rental activities.

5. Rental Real Estate LossesCIn any one year, individuals can offset up to
$25,000 of passive losses from rental real estate against active and portfolio
income.

1. The $25,000 maximum is reduced by 50% of the difference between

the taxpayer=s modified AGI and $100,000.
2. Thus, when the taxpayer=s modified AGI reaches $150,000, the offset
is eliminate.
3. This offset is available to those who actively participate in rental real
estate activities. Two qualifications:

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 (1) The taxpayer must own at least 10% of the fair market value of
all interests in the rental property.
(2) The taxpayer must either contribute to the activity=s
management decisions in a significant and bona fide way or
actively participate in arranging for others to make such
decisions.

4. TRANSACTIONS BETWEEN PARTNER AND PARTNERSHIP

1. GUARANTEED PAYMENTS p. 10-37

1. A guaranteed payment is a payment for services performed by the partner or

for the use of the partner=s capital but not dependent on partnership income.
Guaranteed payments are usually expressed as a fixed-dollar amount or as a
percentage of capital that the partner has invested in the partnership.

2. Guaranteed payments are deductible (or capitalized) by the entity. Deductible

guarantee payments can create an ordinary loss for the partnership.

3. A partner who receives guaranteed payments during a partnership year must

include the payments in income as if they were received on the last day of the
partnership year.

4. Guaranteed payments are always taxable as ordinary income to the recipient

partner.

PROBLEM 39

2. OTHER TRANSACTIONS BETWEEN A PARTNER AND A PARTNERSHIP p.

10-39

1. Certain transactions between Partner and Partnership are treated as if the

partner were an outsider, dealing at arm=s length. Such transactions include:
1. Loan transactions
2. Rental payments
3. Sales of property between partner and partnership (generally).

2. Payments from an accrual basis partnership to a cash basis partner?

1. A guaranteed payment is included in the partner=s income on the last
day of the partnership year when it is properly accrued by the
partnership, even though the payment may not be made to the partner
until the next taxable year.
2. Conversely, the partner=s method of accounting controls the timing of
the deduction if the payment is treated as made to an outsider.

3. A partnership cannot claim a deduction until it actually makes the payment to

the cash basis partner, but it could accrue and deduct payment due to an
accrual basis partner even if payment was not yet made.

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 4. Sales of Property
1. Loss on property sale between partnership & person controlling >
50% interest?
(1) No loss recognized on property sale. Person is considered a
Arelated party@ to the partnership.
(2) Any disallowed loss may be used in the future to offset a
realized gain on a subsequent sale by the person.
2. Gain on property sale between partnership & person controlling >
50%?
(1) Any gain realized on a sale or exchange must be recognized as
ordinary income.
(2) Exception: Can be treated as capital asset if capital to seller and
buyer.
PROBLEM 41
3. PARTNERS AS EMPLOYEES p. 10-40

1. A partner usually does not qualify as an employee for tax purposes.

2. Partner receiving guaranteed payments is not regarded as an employee of the
partnership for purposes of withholding taxes.
3. Concept Summary 10-3 on page 10-41 reviews partner-partnership
transactions.

5. TAX PLANNING CONSIDERATIONS

1. CHOOSING PARTNERSHIP TAXATION p.10-40

2. FORMATION AND OPERATION OF A PARTNERSHIP p.10-40

1. Potential partners should be cautious in transferring assets to a partnership to

ensure they are not required to recognize any gain

2. The nonrecognition provisions of a partnership ('721) are similar to those of a

corporation ('351) although a partner may make a tax-deferred contribution
of assets to A partnership at any time. This is not available to less-than -
controlling shareholders in a corporation.

3. Partners should plan appropriately for the tax benefits and pitfalls of the
partnership. The partnership agreement can ensure proper planning.

3. TRANSACTIONS BETWEEN PARTNERS AND PARTNERSHIP p.10-41

1. Partners should be careful when engaging in transactions with the partnership.

1. A partner who owns a majority of the partnership can not recognize a

loss on property sold to the partnership

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 2. A partner who owns a majority of the partnership is taxed on property
sold to the partnership at a gain if the asset is not used as a capital
asset.

2. Leasing is an alternative to selling to a partnership.

3. The timing of the deduction for payments by accrual basis partnerships to cash
basis partners varies depending on whether the payment is a guaranteed
payment or is treated as a payment to an outsider.

1. If a guaranteed payment deduction occurs when the partnership makes the

accrual.
2. If treated as a payment to an outsider actual date the payment is made
controls the timing of the deduction.

4. DRAFTING A PARTNERSHIP AGREEMENT p.10-42

A partnership agreement can govern a partner=s share of income, gain, loss, deduction or
credit; therefore, a carefully constructed agreement should be formed to ensure a
measure of certainty as to the tax consequences of their activities.

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